The Investment Checklist

by Michael Shearn

  A business with a high renewal rate on its services typically has pricing power. For example, financial-services information provider FactSet Research System’s client-retention rate from 2002 to 2008 was greater than 90 percent. As a result of its high client-retention rate, FactSet is able to raise its prices when contracts renew. In contrast, a business that is always fighting for customers certainly is in no position to raise prices. It must typically decrease prices to attract new customers.

  Low Price Sensitivity

  To determine how price sensitive a customer is, find out how much of the customer’s budget is spent on the product or service. The higher the percentage of the customer’s budget spent on a product or service, the more likely it is that the customer will be price sensitive, which may impede the ability of a business to raise prices. For example, medical laboratory testing businesses have pricing power because their cost to the customer represents 3 percent of overall medical spending, yet they are pivotal to determining the great majority of treatments. This makes lab-test customers less price sensitive.

  Customers Have Profitable Business Models

  If customers have plenty of cash, or their businesses are highly profitable, they will be less sensitive to pricing. This is true as long as the product does not represent a large part of their overall budget. For example, Bloomberg’s customers are mostly traders, who have highly profitable businesses. The cost of Bloomberg’s financial terminals represents a small percentage of a customer’s overall profits and therefore price is not the first consideration. If customers generate low profits, then they are likely to be under pressure to reduce purchasing costs, as in the case of a clothing manufacturer.

  High-Quality Products or Services

  Sometimes the quality of the product is more important to a purchaser than the price. For example, Precision Castparts is a leading manufacturer of high-quality castings, forgings, and fasteners. Jet aircraft engine manufacturers (such as Rolls-Royce) use Precision Castparts’ parts to construct their engines. It is critical that these engines run smoothly and that components work flawlessly to ensure the engine does not malfunction while an airplane is in flight. Also, many of Precision Castparts’ products last five times longer than competitors’ products. This means that buyers are willing to pay a premium for Precision Castparts’ products because the quality of the product matters more to the customer than price.

  Similarly, Fastenal is an industrial parts supplier that makes sure it can supply a wide range of parts immediately to manufacturers. A simple bolt distributed by Fastenal represents a small percentage of a manufacturer’s budget but can be critical to the operation. Speed and quality of service matter more to the customer than price in this case, because the cost of downtime is significantly higher than the price of the bolt to get the manufacturing plant moving again.

  Are Pricing Advantages Sustainable Rather than Temporary?

  Be certain that price increases are not just dependent on a temporary condition. For example, some commodity-type firms, such as disk drive manufacturers, are able to increase prices on their products when demand exceeds supply, but these price increases tend to be short lived because supply eventually catches up with demand. An example would be during the recession in 2008 when trucking capacity shrunk significantly due to many small carriers ceasing operations. Due to the limited capacity in the market, remaining carriers gained some pricing power over their shippers. The majority of the top 50 carriers increased rates by 3 to 9 percent in 2010, with the flat-bed carriers enjoying the higher end of that range.14 This pricing power is temporary, however, because prices will drop as new carriers begin to enter the market again, expanding capacity.

  Where to Find Pricing Power Information

  Look for pricing power information in the following sources:

  The MD&A section of the 10-K

  Historical operating metrics

  Investor presentations, conference calls, and so on

  Keep an eye out for important pricing power indicators such as:

  Multiple years of increases

  Increases that don’t just offset costs (seen in operating profit per customer and operating income growth)

  Pricing that is higher than competitors

  To determine if a business can raise prices, begin by looking at the Management Discussion and Analysis (MD&A) section found in the 10-K, and read management’s explanations for changes in the gross profit margin. Read at least 5 to 10 years of this section of the 10-K.

  For example, in its 2004 Form 10-K, salt producer Compass Minerals International states: “The increase in gross profit primarily reflects the impact of improved prices and volumes ($8 million and $15.3 million, respectively).”

  Five years later, in the 2009 10-K, the company states: “The gross margin for the salt segment partially offset the decline in gross margin by contributing an increase of approximately $40 million due to price improvements.”

  Compass can raise prices, and it specifies the additional revenues it receives by increasing its prices.

  Next, determine if the price increases are lasting or not. Further reading of Compass’ 10-K and other documents reveals that Compass’ increases have been lasting, as they have been able to raise prices consistently over the last five years.

  Finally, see if these price increases have translated into operating income growth, or if they have been used to offset increased expenses. To do this, compare the gross profit margin to operating-income margin over a one- to five-year period. If the operating-income margin is dropping as the gross margin is increasing, then expenses may be rising faster than price increases.

  Another method to identify pricing power is to calculate historical operating profit metrics. For example, Western Union reports the total number of transactions and operating profit for its consumer division in the 10-K. You can divide consumer transactions by the operating profit for its consumer division to yield a single trending number representing operating profit per consumer transaction. In 2003, operating profit per consumer transaction was $9.44. By 2008, this decreased to $6.51. This downward trend in operating profit per consumer transaction indicates that pricing power is declining. In fact, Western Union disclosed in its 2009 10-K that it re-invests 1 to 3 percent of its revenues in price decreases to increase customer traffic.

  Other useful sources for determining pricing power are company investor presentations, conference calls, or annual reports. These sources may provide other indicators of pricing power, such as whether a business is able to charge more than its competitors. For example, in historical annual reports, Four Seasons Hotels disclosed the daily room-rate premium (known as RevPAR premium) it achieved compared to its competitors. Historically, Four Seasons’ pricing premium was 50 percent greater than its closest competitor, Ritz Carlton.15

  In most cases, if a business has pricing power, it will disclose it. If the business does not disclose increasing prices, then it is highly probable the business does not have pricing power. Look for price increases in the context of other indicators of pricing power: trends in profit per customer, pricing that doesn’t just offset increased costs, and price increases that can continue for multiple years.

  Examine Whether Pricing Power Is Found Throughout the Overall Business or Only a Segment of the Business

  Determine if the business’s pricing power protects all of its revenues or just a percentage of them. Some businesses have pricing power in certain products or services, yet not in the majority of the products or services they offer. For example, airlines set their prices by how much competition they have on a certain route, rather than by distance. As a result, they have pricing power on certain routes rather than all routes. A plane fare from Austin, Texas, to Corpus Christi, Texas, (200 miles) may be more than a fare from New York to Los Angeles (3,000 miles) because there is more competition on the New York-to-Los Angeles route. If more of an airline’s routes are similar to the New York-to-Los Angeles route, the airline has less overa
ll pricing power than it would if more of its routes were like Austin-Corpus Christi.

  Technology Creates Price Transparency

  Technological changes have affected the ability of businesses to increase prices. The Internet in particular has helped create price transparency. In the past, some businesses were able to maintain higher pricing because it was more difficult for customers to compare pricing. For example, consider the changes in hotel room price transparency. In the past, customers relied on travel agents or had to call multiple hotels to compare pricing. In contrast, they now use online travel sites (such as Expedia and Travelocity) to do the same thing instantly. Customers can now easily see hotel pricing, and as a result, they have become more price sensitive. This greater visibility has lowered the room rates that hotels can charge.

  17. Does the business operate in a good or bad industry?

  Investing in the right industry is important because a large part of your potential rate of return is often attributable to the industry you are invested in, as opposed to a specific company you are invested in. As you evaluate an industry as a whole, ask how easy it is to make money in the industry. If it is easy, that’s a good industry to be in, and your chances of making money in your investment are better.

  To Begin, Calculate the Range of Industry Return on Invested Capital

  To begin evaluating the industry, compare the distribution of returns on invested capital (ROIC, which question 26 discusses in more detail, including showing you how to calculate it). If it’s easy to make money in an industry, you will find that most companies are doing well, and there will not be a wide range of distribution of ROIC. If there is a broad range of ROIC, with some companies doing well and some doing poorly, this is a tougher industry to be in.

  For example, the pharmaceutical industry has a consistently high ROIC, with returns ranging from 13 to 21 percent over the last decade.16 The best pharmaceutical businesses are not far from the worst in terms of ROIC. In contrast, ROIC for the major oil companies ranged from 3 to 15 percent over the last decade. This wider and lower range of ROIC indicates that it is harder to make money in this industry.17

  To get a deeper understanding of whether an industry is good or bad, compare the best companies to the worst within the industry. By making comparisons between the extremes in an industry, you will identify the reasons why the industry is good or bad to be in. This information will also help you evaluate other companies if you decide to invest in the industry.

  Another Method of Industry Analysis—from Imperial Capital’s Steve Lister

  To give you more in-depth methods of picking a good industry, I present a case study of the industry research methods of Steve Lister, co-founder of Toronto-based private equity firm Imperial Capital, who has been selecting companies from good industries for many years. Lister’s case study illustrates several methods you can use to understand if the industry as a whole is a good one.

  Lister’s firm has a solid track record of identifying, evaluating, and investing in some of the most profitable industries, such as regional telephone-book publishers and refrigerated warehouses. Lister believes that finding the right industry is what counts most. Like many, Lister believes that your chances of picking a good investment are based more on the industry than on the individual company. He notes that if an industry is growing 5 percent to 8 percent a year, even if you do not identify the best individual company, your performance will still likely be good. Furthermore, Lister has discovered that over time, the profitability of a business will eventually trend toward the mean of the industry, as it is difficult for any business to outperform the industry for a long period of time.

  Lister’s firm has developed a scorecard system with 100 different items that helps him evaluate the economics of an industry. As Lister says:

  We score an industry on 100 items every time. There is a lot of judgment in terms of how to understand things such as the volatility of customer demand, profit margins, pricing power, and barriers to entry. We go through all of these items and rate them and create a sort of index. Maybe we are wrong on 5 percent to 10 percent of the items, but at the end of the day, it is the relative score that matters. If an industry scores positively on only 50 of the 100 items, we will pass on the industry, but if the industry scores anywhere from 60 to 75 of the 100 items, we will look for a business within that industry to invest in.

  Some of the questions on Imperial Capital’s scorecard include:

  What drives the industry?

  How do people compete within the industry?

  What is the larger macro picture?

  What are the industry trends?

  What is the average cash-conversion cycle for the industry?

  What is the industry’s exposure to cyclical markets?

  Does the industry have the ability to pass on price increases?

  What is the volatility of demand from customers?

  Once analysts at Imperial Capital narrow down the industries they will consider investing in, they then research the industry more closely to understand the trends in demand and what is driving demand. Lister identifies whether the trends are negative or positive, and whether they are temporary or structural. This allows him to understand whether the trends are sustainable.

  For example, when Lister and his team evaluated the healthcare industry, they started by looking at more than 100 healthcare segments, or what he calls niches. They analyzed the growth rates, profitability, the number of businesses, and reimbursement risk for each of these niches. Then they developed a ranking of each of the different healthcare niches, based on this underlying research. Once they narrowed down the list to 12 niches with above-average profitability, they looked for healthcare practitioners who could help them answer the questions in their scorecard and further narrow down the industries that they could invest in. These healthcare practitioners were former or existing CEOs of businesses who had “lived, slept, and breathed the industry for a long time.” As Lister says, “The only way you can know where the skeletons are buried in an industry is to partner with someone who knows where they are.” To locate these CEO partners, Lister and his team go to industry conferences and use their established network of industry contacts.

  One business that Lister’s firm invested in because it met the majority of Imperial Capital’s criteria (75 out of 100) was Associated Freezers Corporation, a refrigerated warehousing company. There were several factors that attracted Lister and his team to Associated Freezers, including these:

  Underlying demand was strong. As women entered the workforce, frozen foods made up a larger part of people’s diets. Supermarkets showed evidence of this increased demand as they increased the number of frozen foods aisles.

  The quality of frozen foods improved. The old style TV dinner was replaced with more popular choices and higher-quality ingredients.

  Price was not the primary determinant. The customers (frozen-food manufacturers) chose warehouses based on service, real-time links to inventory, good temperature control, quality, and on-time delivery, not on price.

  There were barriers to entry. Industry regulation forced refrigerated warehouses to staff engineers because the extremely large refrigeration equipment is dangerous. Because of the expense and expertise required to build the refrigerated warehouses, entry was constrained by capital.

  The financial characteristics were strong. Earnings before interest, taxes, depreciation, and amortization (EBITDA) margins exceeded 36 percent once a refrigerated warehouse was built, and the maintenance capital expenditures were minimal. This allowed investors to earn excess free-cash flows.

  Finally, the average cash-conversion cycle was 120 days, so refrigerated warehouses could grow without using a lot of borrowed cash.

  Lister and his investment partners were extremely successful in this investment because Lister and his firm had identified a good industry.

  18. How has the industry evolved over time?

  Understanding how an industry evolved
will help you evaluate the business in the context of its competition, its operating environment, and the various other forces that shape it. When you study an industry, you will pick up on factors and forces that are not as obvious as when you study only one business. To understand the industry well, study its history over a long period (i.e., more than 10 years). Seeing change over time will help you pick up on factors and major forces that are not apparent in only one period.

  For example, when I was interested in investing in a large advertising agency, I studied not only the individual agency, but the entire industry. I did not fully understand all the forces that affected the industry until I saw them unfold over time.

  One of the main services of an ad agency, historically, has been ad placement. For decades, ad agencies charged on the basis of billings: In other words, the agency was paid a percentage of the amount their clients paid to television stations, newspapers, magazines, and so on, to run their ads, so if an ad campaign for a client cost $200 million, the ad agency’s commission might be 10 percent of that, or $20 million. Obviously, this was very profitable for large agencies. In fact, the operating margins for the advertising industry used to exceed 20 percent.

  As the industry consolidated, companies leveraged their balance sheets to acquire other agencies, assuming that those healthy margins would continue indefinitely. Two things happened that changed the margins within the advertising-agency industry. First, companies began to realize that paying a percentage of their total advertising bill to the advertising agencies wasn’t a good value for them. They began to see that their sales results weren’t tied to how much they paid, but instead depended on several other factors, including the quality of the ad, the research that went into it, and the number of potential customers it reached. Second, with the growth of Internet advertising, companies who wanted mass-market or national advertising campaigns were no longer stuck with major television networks and limited print media as the only avenues for reaching customers. Instead there were now hundreds of web sites where advertisements could reach a nationwide audience. Mass markets became fragmented and the brokering power of the large agencies diminished significantly. The large advertising agencies had to move to a lower pricing model, and operating margins began to decrease.